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1 Chapter 15: The Transition from Communism to a Market Economy in Russia -- Continued (revised November 2006) 1. Capital Markets Capital markets are the means by which the savings of the population are channeled to the businesses for the purpose of buying new capital goods. In the United States, this important function is performed by banks and other financial institutions. But such institutions did not exist in the former Soviet Union. Russia has been trying to develop new capital markets, but it has not totally succeeded as of yet. As of 1988, there were just four government owned banks in the entire former Soviet Union. Then under the Gorbachev reforms, cooperative banks were allowed for the first time. Between 1988 and 1990, almost 1,000 new cooperative banks were created. One of these, the MOST Bank, started by Vladimir Gusinsky, was discussed in Chapter 14. By 1995, there were over 2,000 banks in existence in Russia. Most of these were small banks. Over time, some of these banks consolidated into larger banks while many other banks failed. As of 2000, there were 1,349 banks in existence in Russia. For Russian households, about 2/3 of savings were held either as domestic currency (rubles) or as foreign currency (US Dollars). Only 1/3 was held in a financial institution. And of the money that was held as savings in financial institutions, about 85% was saved in one bank, called the Savings Bank (Sberbank). This bank is majority owned by the Central Bank of Russia and has branches all over the country. Its deposits are government guaranteed. The other banks in Russia receive very few deposits from households. Instead, their deposits come from businesses or from government agencies. The households simply distrust these banks and with good reason. Many have been poorly run and had inadequate funding. Accounting standards have been very weak. In 1994 and 1995, there were more than 1,000 pyramid scheme scandals. About 30 million people became victims of these scandals. Many of the banks speculated in the foreign exchange market and went broke. And it didn’t help that, in a period of high inflation, the new banks paid savers an interest rate that was less than the inflation rate (that is, a real interest rate that was negative). This distrust of the new private banks came at a time when the savings of Russian households rose considerably. In the mid-1980s, Russian households saved only about 5% of their incomes, on average. By any standard, this is a very low percent. By the mid1990s, this had risen to almost 30%, a very high savings rate. Economists are not certain as to why this large increase in savings occurred. It could have been a result of increasing uncertainty, it could have been a result of the great reduction in programs for retirement, disability, or health care, it could have been a result of the new ability to buy homes or apartments, or it could have been a result of other changes. The problem is that for the enterprises to be able to borrow money to purchase new capital goods, these savings need to be placed in financial institutions. And as we saw, this was not happening. Compounding the problem was the fact that those private banks that did have funds to lend were very reluctant to lend them to the new Russian enterprises. Russian enterprises were not good potential borrowers because they had commonly incurred debt that they could not pay. The total debt of the Russian enterprises was 2 extremely high. And a considerable portion of all of the wages and salaries were unpaid, as noted in Chapter 14. Most of the banks, fearful of the uncertain political climate and of the inability of the enterprises to repay loans, either refused to make loans at all or would not make them for longer than one year. Instead of lending to the new Russian enterprises, the private banks, who received their deposits from businesses or government agencies, either held them as foreign money in banks in the West or used them to buy debt of the Russian federal government. Even the Savings Bank loaned most of its deposits to the federal government. (They bought what are called GKOs – similar to American Treasury Bills.) The financial crisis of 1998 will be discussed below. At that time, the Russian federal government defaulted on its debt. The GKOs became essentially worthless and many of the banks holding them became insolvent. In the 9 months after the crisis of August of 1998, the value of the commercial banks fell over 50%. After the crisis, the restructuring of Russia’s banks proceeded very slowly. In general, the new private banks have not yet been particularly relevant to Russian economic development. Investment funds, similar to mutual funds in the United States, were slow to develop in Russia. Russian Investment funds hold only about 10% of the shares of Russian corporations. (Compare this to the 60% owned by investment funds in the Czech Republic.) So banks, investment funds, and even foreign investors have not been significant sources of financing for Russian enterprises. There is yet another way for companies to obtain the funds they need to finance their purchases of new capital goods. They can sell shares of stock to the public. This requires the development of a securities, or stock, market. By 1995, there were already some 66 different stock exchanges operating in Russia. The privatization process described in the previous chapter provided training for future brokers, as many got their start by trading vouchers. Yet, the Russian stock markets have not become as significant as had been hoped (as of the date of this writing). One reason is that information to potential buyers of stock is inadequate. Information is inadequate for at least two reasons. First, most trading is done on an over-the-counter basis. There is no equivalent of the American Dow Jones Average or NASDAQ that is relayed to potential stock buyers all over the country. Therefore, it is difficult for potential buyers to know what is occurring on the Russian stock markets in a timely manner. Second, information about the companies is also difficult to interpret. The Russian accounting system is different from that used in the United States or Europe. In Russia, the goal of the accounting system has been to find ways to understate profits so as to reduce corporate taxes. The goal has not been to accurately measure the profits of the company. Until 1994, the Russian stock markets were dominated by pyramid schemes (swindles). Laws protecting stockholder rights were slow to develop in Russia. When those laws were finally enacted in the late 1990s, they were poorly enforced. A third reason that Russian stock markets have yet to become a significant factor in Russian economic development is that management often holds the majority of the shares (as noted in the previous chapter) and is hesitant to sell its shares of stock. Foreigners have been very important buyers in the Russian securities markets, especially the stock of energy companies. By the end of 1996, foreigners held about 15% 3 of the stock of the 50 largest Russian companies. Since 1996, foreign pension funds bought much of this stock. Foreigners retreated from Russian stock markets during the crisis of 1998 (discussed below). But some foreigners achieved great wealth buying stock in Russian companies (which, as noted in the previous chapter, were very undervalued). Because of the problems of banks and securities markets, the buying of new capital goods by enterprises declined significantly in the 1990s. This decline was a main reason for the economic problems suffered by Russia in the 1990s (see below). Throughout the 1990s, most new capital goods were paid for out of the profits of the Russian companies. Less than 10% of the capital goods were paid for by borrowing from the new banks or by selling shares of stock. Developing institutions that will allow the newly privatized enterprises to borrow or sell shares to pay for new capital goods remains a challenge for Russia. But there is a huge need for new capital goods if Russia is to grow economically. The “Economic Freedom Index” estimates the investment climate in 161 countries. In 2000, Russia occupied 121st place. This poor investment climate acts to hold down economic growth in Russia. 2. Stabilization One of the main problems faced by Russia in the early 1990s was rampant inflation. As mentioned above, prices rose 250% in 1992 as the prices were freed from government regulation. That was to be expected. What was not expected was that prices would keep on rising – typically at a rate of 25% per month! This is called hyperinflation. Prices in Russia rose at the following rates per year: 1991 1992 1993 161% 1994 2,506% 1995 840% 1996 204% 1997 10.97% 128.6% 1998 84.5% 21.8% 1999 36.8% Under the end of the 1980s, the world had recorded only 16 cases of hyperinflation. But from 1989 through the early 1990s, there were 11 more cases, all in the Eastern European countries undertaking the transition from communism. This magnitude of inflation makes it impossible for markets to function in an efficient manner. This high rate of inflation also destroys the savings of the well-to-do and the elderly. And this high rate of inflation undermines confidence in the ruble. Few people wanted to hold rubles. Instead, in most regions of Russia, transactions took place in American dollars. So, in order to get the Russian economy to grow, and also in order to help Boris Yeltsin get re-elected as President of Russia, it was necessary to get the inflation under control. This required reducing the growth of the number of rubles in circulation (the Russian money supply). The hyperinflation had been connected to very large budget deficits (the Russian government spending more than it took in as tax revenues). This is explained in the section on the Russian Financial Crisis below. As a percent of GDP, Russian budget deficits were the following: 4 1992 1993 18.9% 1994 10.4% 7.3% 1995 6.0% 1996 8.9% 1997 7.6% 1998 8.0% 1999 1.1% For perspective on these data, consider that the very large American budget deficits in 2002 and 2003 were not much more than 3% of the American GDP. These very high Russian budget deficits were financed by the creation of new rubles. (The Russian government had to pay for the spending that exceeded its tax revenues. It did this by printing new money.) “More rubles chasing fewer goods” is a sure recipe for inflation. The hyperinflation of the 1990s was also connected to the large amount of central bank loans. The Bank of Russia (the Russian central bank) would simply create the new rubles to lend to some Russian enterprises. This, once again, meant there was more money in Russia. And more money chasing fewer goods causes inflation. Reducing this source of inflation in the new Russian democracy was difficult because some important political interests in Russia were benefiting from these central bank loans. First, the central bank of Russia earned interest when it made loans to various enterprises. The interest payments on these loans indeed became a major source of the profits of the central bank. About 2/3 of these profits went into a social fund to “stimulate the performance” of the central bank’s employees. It was also rumored that some employees of the central bank were receiving bribes from certain enterprises to gain access to these central bank loans. So the central bank’s employees had an interest in maintaining these loans and therefore in keeping the growth of the money supply high. Second, the commercial banks benefited from the central bank lending. First, although they did not lend much to enterprises themselves, they handled the loans from the central bank to the enterprises and earned fees for doing so. Second, they were also able to take bribes from enterprises seeking access to these loans. Third, they were able to direct some of the central bank loans to enterprises that were owned by the commercial banks (or by the banks’ managers). Fourth, the commercial banks gained from inflation because they took in deposits and paid a negative real interest rate on these deposits (that is, the interest they paid did not even equal the rise in prices). They used these deposits to speculate on commodities or on foreign exchange to try to earn high profits. (In contrast, it would be illegal for American banks to do this.) Not only did the commercial banks desire to maintain the policy of central bank lending to enterprises, they were in a powerful political position to lobby to maintain this policy. They had this powerful political position because they provided money to help finance electoral campaigns and because they provided attractive places of employment for the government ministers after they left office. Third, there were the enterprises that received the loans from the central bank. These loans were very substantial and were made at negative real interest rates (again, the interest rate paid did not cover the rise in prices). Favored enterprises gained greatly from these cheap loans. Managers of these enterprises and their unions lobbied strongly to maintain these loans. What existed was a good example of what is called the special interest effect. The small group of people who gained from the loans that caused the inflation was very conscious of the gain they received and were well organized to lobby for the continuation of the policies that generated these gains. The victims of the hyperinflation, the population in total, were disorganized and were not well aware that 5 the cause of the hyperinflation was the large amount of loans from the central bank. There was no pressure group arguing for an end to the inflation. Inflation continued at very high rates through 1999. Then, as we will see below, the Russian financial crisis occurred. This was an economic disaster for Russia. Overall production in Russia was 30% lower in 2000 than it had been in 1990. The financial crisis provided the motivation to take action to reduce the inflation rates. This required first getting control of the budget deficits. The budget deficit fell from 8.9% of Russian GDP in 1996 to 1.1% of GDP by 1999 (see above). Since 2000, as you can see in the data below, the Russian budget has been in surplus (revenues have exceeded spending). A good part of this has been the result of increasing revenues from oil as the price of oil has risen. Reducing inflation also required getting control of the Russian money supply. This has not been done, as you can see in the data below. (For perspective, in the United States, the money supply rarely rises by more than 5% per year.) By American and European standards, inflation rates were still high in Russia through 2005. However, they are projected to come down into single digits in 2007, 2008, and 2009. But at least by 2000, the hyperinflation was over. Year 2000 2001 2002 2003 2004 2005 Year 1997 1998 1999 2000 2001 2002 2003 2004 2005 Inflation Rate Budget Surplus as a Percent of GDP 20.8% 1.4% 18.6% 3.0% 15.1% 1.7% 12.0% 1.7% 11.7% 10.9% Growth Rate of the Money Supply (M-2) 29.8% 21.3% 57.5% 61.5% 39.7% 32.4% 50.5% 35.8% 38.6% 3. Entrance into the Global Economy Another major aspect of the transition from communism to a market economy has been the opening of Russia to the world economy. We know that resistance to international trade (autarky) had been part of the communist economy. In the communist period, the ruble exchange rate had been set arbitrarily by the government. Russian people had been prohibited from owning foreign currencies. If the new Russia were to become open to international trade, the Russian ruble had to become convertible. This means that the ruble had to be traded freely in the foreign exchange markets of the world. 6 The creation of a convertible Russian ruble took several years to accomplish. In April of 1991, the Russian government authorized currency exchanges. Russians were permitted to hold foreign currencies for the first time. However, for much of the 1990s, there were limitations on these holdings of foreign currencies. Those who earned foreign currencies by selling abroad were required to sell a portion of them to the Russian Central Bank. This, of course, reduced the incentive to earn foreign currency. Although there are still some restrictions today, the Russian ruble has been trading in foreign exchange markets. Throughout most of the 1990s, the Russian ruble depreciated in relation to the dollar. This depreciation has resulted from the very high inflation rates experienced in Russia. In 1998, there was a major economic crisis in Russia (to be discussed below). The Russian ruble was converted into the New Russian Ruble at the rate of 1000 old Russian rubles to 1 new Russian ruble. At the time of this writing (2006), it took about 26.7 new Russian rubles to buy $1 (this would be 26,700 old Russian rubles). You can see the rapid depreciation of the Russian ruble in the 1990s in the following table: 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Russian Rubles Per Dollar 179 572 1582 4562 5126 5785 9965 Old Rubles (9.965 New Rubles) 25,400 Old Rubles (25.4 New Rubles) 27.0 New Rubles 28.16 New Rubles 30.14 New Rubles 30.7 New Rubles 29.0 New Rubles 28.3 New Rubles In 1998, the Russian ruble was not sold on foreign exchange markets at all for awhile due to the great political uncertainty in Russia. The depreciation of the Russian ruble, the high inflation rates in Russia, and the restrictions on holding foreign exchange made it difficult for the new Russia to become fully engaged in international trade. However, as you can see in the data, since 1999, the Russian ruble has not depreciated very much (25.4 to the dollar in 1999 compared to 26.7 to the dollar in 2006). This stability, combined with lower inflation rates and easing on the restrictions against holding foreign exchange, has eased Russia’s transition into the global economy. In addition to the problems of making the ruble convertible, in the 1990s, there was only a weak commitment on the part of the Russian government to open Russia to international trade. Exports were still regulated by export taxes, quotas, and licenses. (These quotas and licenses were a source of income for government officials through the receipt of bribes.) Domestic producers in many Russian industries also were protected from imports through tariffs and import quotas. It should be no surprise 7 that the amount of trade actually fell after 1990. This decline in trade contributed to the economic disaster of the early 1990s in Russia. But from 1993 to 2003, trade rebounded very well. Russian exports fell from over $70 billion in 1990 to over $40 billion by 1992. But after that, they increased considerably (except for 1997 and 1998) and reached almost $140 billion by 2003. Since 1999, Russian exports have been increasing at rates of more than 5% each year. The collapse of communism brought a quick and large-scale reorientation in the direction of Russian trade. Most of this took place in the early 1990s. In 1990, nearly all of Russia’s exports had gone to the countries that were then part of the Soviet Union or were part of the Soviet Bloc. By 2002, only about one-fourth of Russia’s exports went to these countries. In 2004, more than half of Russia’s exports were going to the countries of the European Union and another 6% was going to the United States – areas that had received practically no Russian exports as late as 1990. The change in Russia’s trade appears to have followed the law of comparative advantage well. Again, most of this change appears to have taken place in the early 1990s. Russia has been exporting those goods for which it has a comparative advantage (natural resources such as oil) and has been importing those goods for which it has a comparative disadvantage (consumer goods and capital goods). The opening to the world economy has brought a large-scale reduction in the proportion machinery goods in Russian exports and an expansion in the proportion of energy. The importing of consumer goods has provided the main competition for Russian industry (recall that Russian industry has tended toward monopoly). As of this writing (2006), Russia is not a member of the World Trade Organization (WTO). It has signed an agreement with the United States to become a member very soon. But it is still the largest non-member, despite having first applied for membership in 1993. Its accession as a member has been hotly debated both inside and outside of Russia. Becoming a member of the WTO would require Russia to reduce its restrictions on imports. This would hurt those Russian companies that have been protected against imports. Those people represent a strong political interest. But becoming a member of the WTO would also open the markets of the other 150 WTO member countries to Russia’s exports. Studies indicate that Russia becoming a member of the WTO could cause a large increase in Russia’s exports to WTO member countries. Accession to the WTO would also make Russia part of a rules-based trading system. This should provide an incentive to improve rules-based governance within Russia. (As you might guess, this is opposed by those whose wealth is derived greatly from bribery.) Accession to the WTO would also make foreign investment in Russia more attractive. This is the major reason that Russia has sought entry. As a prelude to its accession to the WTO, Russia has been negotiating bilateral market access deals with major WTO member countries. In 2004, it signed such a deal with the European Union. Russia’s opening to the world economy has also been impaired by Russia’s foreign debt. Russia took over the debt of the former Soviet Union and then added some of its own. By the mid-1990s, this debt of the Russian government exceeded $100 billion dollars. The need to pay this foreign debt is the reason that those who earn foreign currency by selling products abroad have to sell part of that foreign currency to the Russian Central Bank. 8 Finally, let us very briefly mention Russia’s agricultural sector. One would expect Russia to become a major exporter of agricultural products. Under communism, Russia was an importer of grains despite having some of the best agricultural land in the world. Yet in the new Russia, reforms of the agricultural sector have been minimal. Most farms are still either state farms or collective farms. Agricultural performance in the new Russia has been poor. Meat, milk, egg, and grain production all declined considerably in the 1990s and have rebounded only slowly. Russia has failed to become a major exporter of agricultural products as of yet. The Russian Financial Crisis of 1998 By 1997, Russia had become one of the most popular destinations for financial managers in the United States and Europe to invest their money. Russia was considered safe because it was believed that if any problem occurred, Russia would be bailed out by the International Monetary Fund. Russia, after all, was too big and too nuclear to be allowed to fail. As we saw, in 1997 Russia had a government budget deficit. As with any other country with a government budget deficit, it financed this deficit by borrowing. The Russian government borrowed on a short-term basis from foreign financial institutions. (These were called GKOs.) These loans were payable in rubles, not dollars. But the ruble – dollar exchange rate had been reasonably constant, so the lenders did not fear that they were taking much risk. The foreign lenders liked these loans because they paid interest rates in the 20% to 30% range and because their short term (3 months) made the risk seem low (they did not think that much could go wrong in only three months). By the end of 1998, Russians owed foreigners about $214 billion in total. By early 1998, foreign financial institutions had become less willing to buy the Russian government debt (that is, to lend to the Russian government) for several reasons. First, the recession in East Asia reduced the demand for oil and natural gas, Russia’s main export products. Second, the problems of East Asia caused financial managers to look more negatively at all emerging markets, including that of Russia. Third, there was political uncertainty when, in the spring of 1998, President Yeltsin fired his Prime Minister. While President Yeltsin maintained his position (despite an impeachment attempt in 1999), the rest of the government had been changed several times. In a year and a half, there had been four new governments. And fourth, in May of 1998, the coal miners, tired of having their wages go unpaid, began a strike, blocking the Trans-Siberian Railway. Faced with the unwillingness of foreign financial institutions to lend it the money that it needed, the Russian government was forced to raise the interest rates it would pay. Within one month, these interest rates had topped 150%. The reduced willingness of the financial institutions to lend to Russia should cause the Russian ruble to depreciate against the American dollar. (When foreign financial institutions lend to Russia, they need to buy Russian rubles to lend to the Russian government. But now, they were lending less. So they would be buying fewer Russian rubles, reducing the value of the Russian ruble.) However, both the Russian government and the International Monetary Fund desired that the ruble – dollar exchange rate remain stable. So, in July of 1998, the International Monetary Fund arranged for a $22.5 billion loan to Russia to help support the ruble-dollar exchange rate. (Russia was to use these 9 dollars to buy Russian rubles and thereby prevent the Russian ruble from going down in value.) In return, Russia promised to lower its budget deficit significantly (partly by collecting the taxes due from those that had been avoiding paying their taxes). In addition, the Russian government agreed to exchange part of its short-term debt for longer-term bonds. These longer-term bonds were to be repayable in dollars. The new longer-term bonds of the Russian government were bought mainly by Russian private banks. The Russian private banks paid for these bonds by borrowing in dollars from foreign financial institutions. Because the government sold more and more of these bonds to finance its budget deficits, the prices of these bonds fell. The decline in the prices of the bonds caused the value of the assets of the Russian banks that held these bonds to decline as well. As the value of the assets of the Russian banks declined, the foreign financial institutions feared that the Russian banks would not be able to pay their debts. So the Russian banks received calls from the foreign financial institutions to pay their debts immediately. Hearing this news, the Russian people feared a collapse of the Russian banking system. Because of this fear, they withdrew their accounts at the Russian banks and tried to convert them into dollars. As the runs on banks continued and grew, the Russian banks could not pay their debts to the foreign financial institutions. Ultimately, on August 17, 1998, the Russian government defaulted on its borrowing, both to Russians and to foreigners. Because of Russia’s default, foreign investors lost considerably. Accounts at banks were frozen and banks were closed. And in August of 1998, as we saw above, the Russian government finally allowed the value of the ruble to fall. Once the crisis passed, the Russian economy recovered relatively quickly. (This was also true for most of the countries that experienced financial crisis in this period.) As we saw above, budget deficits were reduced by the fall of 1999. Oil prices rose in 1999 and then rose much more after 2003, greatly improving the Russian economic performance. Inflation rates, while still high by American standards, declined to more reasonable levels. As we saw, the ruble- dollar exchange rate has basically stabilized after 1999. The financial crisis caused great hardship in Russia for a couple of years. However, from the perspective of 2006, it does not appear to have had long-lasting impacts. 4. Inequality, Poverty, and Health Care Russia undertook the transition from communism to a market economy relatively quickly. This has been known as “shock therapy”. (We will contrast this with China, whose transition was much slower.) One result of the rapid shift to a market economy has been an increase in inequality in Russia. Inequality is measured by the Gini Index. This is a number between zero and one. The higher the number the greater is the inequality of incomes. And the lower the number the greater is the equality of incomes. According to the official Russian data, the Gini Index rose from 0.26 in 1991 to 0.40 by 2000. The World Bank estimates the Gini Index to be 0.46 in 2000. By comparison, the Gini Index for the United States is approximately 0.41. So Russia has changed from a relatively equal society under communism to a society that is slightly more unequal than the United States. However, it needs to be noted that most of this increase in inequality occurred in the early 1990s. According to the World Bank, the Gini Index for Russia had 10 reached 0.496 by 1994. After 1994, inequality stabilized in Russia but has not been reduced. The following table shows the distribution of income in 1980 and in 1995 by quintiles: Percent of Total Household Income in Russia Quintile 1980 1995 First 10.1% 5.5% Second 14.8% 10.2% Third 18.6% 15.0% Fourth 23.1% 22.4% Fifth 33.4% 46.9% A parallel change has been the increase in the number of people officially poor in Russia. The official statistics define poverty as not having an income sufficient for minimum subsistence. According to this measure, the number of Russian people who were officially poor increased from 11% of the population in 1989 to 30% of the population by 1995 (a different measure estimates this to be 40% in 1995). In 1995, the average real wage was only about one-third of its 1991 level and almost half of workingage adults were owed wages. Poverty levels peaked in 1995 and have declined gradually since then. However, they are still high, reaching about 16% of the population in 2005 (compared to about 13% for the United States and 5% to 10% for most countries of Europe). Some of this increase in poverty has been related to a decline in the social safety net. Pensions for those of retirement age (55 for women and 60 for men) have been maintained and have been adjusted for inflation. Those who are retired have not been driven into poverty. But support for families with children has been seriously reduced. Indeed, poverty rates in Russia are highest for families with three or more children. And benefits for the unemployed have been reduced to less than one-fifth of their 1991 level at a time during which unemployment was rising and during which about 80% of the unemployed people are unemployment for at least three months. In the 1990s, government transfers to the poor were reduced significantly. As of 1995, about 40% of very poor families received no public transfers at all from either the Russian government or their local governments. Perhaps the most noted change in Russia since the shift to a market economy has been the decline in health standards. This is best illustrated by the death rate. The death rate in Russia increased from 7.6 deaths per 1,000 people in 1965 to 11.2 deaths per 1,000 people in 1990 and then to 15.3 deaths per 1,000 people in 2000. The life expectancy at birth for a Russian was 69.5 years in 1965 and 69 years in 1990 before falling to 64 years in 2004 (and then rising to 65.8 years in 2005). For males, the life expectancy at birth fell to only 57 in 1994 before rising. However, it was still only 60 in 1999 (compared to about 75 years for men in the United States and even older for men in most of Europe). The main explanation for this decline in health standards has been the large increase in alcohol consumption. (Russian Vodka is commonly 45% alcohol or more. Binge drinking is common.) Deaths of working age males increased from 30 per 100,000 people in 1991 to 103 per 100,000 people in 1994 before falling back to 46 per 100,000 people by 1998. Some of this excessive drinking may have been caused by stresses brought on by the transition process. Another explanation for these statistics is 11 the increase in crime in Russia. Death rates of males because of murder increased from 23 per 100,000 people in 1990 to 52 per 100,000 people in 1994 before falling back to 36 per 100,000 people in 1998. There does not seem to be any serious malnutrition in Russia causing the increase in the death rate; but there is evidence that the diets of large numbers of people became less healthy. Some of the health deterioration may also be due to environmental problems. Only half of the Russian people in the late 1990s had access to safe drinking water. And only 15% of the people lived in cities in which the air was not significantly polluted. It is hard to blame this health decline on the health care system. The number of doctors per 1,000 people and the number of visits to doctors are about the same as before. The number of hospital beds and the number of hospital stays have declined somewhat as there have been financial constraints on hospitals. The infant mortality rate (deaths before age one) has actually declined slightly. So the decline in health seems to be related more to changes in behaviors and less to significant reductions in the availability of health care. 5. Conclusions: Economic Performance in the New Russia In assessing the performance of the Russian economy, some writers have used the analogy of a freeway. One can drive around for many miles on city streets, getting lost, in order to find the entrance to a freeway. But once one does find the entrance, one can usually travel at great speeds. Using this analogy, Russia has been “looking for the entrance to the freeway”. As with the driver, its economic performance has not been good. Once it does “find the freeway”, it is hoped that the Russian economy can grow very fast. At the time of this writing, the future of the Russian economy appears to be better than the recent past. Let us examine the New Russia in terms of the goals we set for an economy in Chapter 1. Our first goals involve economic growth and the standard of living. As we have noted, overall production in Russia declined greatly through most of the 1990s. This decline in production was about 39% between 1991 and 1998. The decline in overall production largely resulted from the decline in production of new capital goods. (Purchases of capital goods in 1997 were equal to only 17% the purchases of 1990.) But it also resulted from the decline in international trade and in agricultural production. The decline in production in Russia in the 1990s is substantially greater than that experienced by the United States in the Great Depression of the 1930s (about 25%). It is true that all of the Eastern European countries that also shifted to a market economy experienced a decline in production. But for most of these other countries, the decline lasted only about two years and was followed by growth. For Russia, the decline continued for nearly a decade. Even if the transition to a market economy is ultimately very successful, the Russian people paid an enormous cost. It appears that since the end of the financial crisis, production in Russia has grown at a substantial pace. Russian GDP and Industrial Production grew at the following rates in recent years: 12 2001 GDP Growth Rate Industrial Production 5.1% 4.9% 2002 4.7% 3.7% 2003 7.3% 7.0% 2004 7.2% 8.3% 2005 6.4% 4.0% If economic growth continues at these rates, the Russian economy will indeed have found the “entrance to the freeway”. One mistake that has been made about the former Soviet Union is to assume that it was a rich country. This mistake was made because the Soviet Union was militarily powerful. But the former Soviet Union then and Russia today must be classified as a middle income country. GDP per capita (in purchasing power parity) is about $8,000. This is similar to Mexico and Turkey. But it is less than one-fifth the level of the United States. Once it is realized that the standard of living in Russia is low by American or European standards, one can appreciate that standards of living in Russia have been rising, albeit slowly. Consumption by households rose about 3% between 1990 and 2002. Average living space per person increased from 16 square meters to 19 square meters. This is still very small by American standards. (This is an average of 126 square feet per person. So a family of four would average about 500 square feet, a small space indeed.) However, more than half of this living space is privately owned now compared to about one quarter in 1990. The proportion of households with radios, televisions, refrigerators, washing machines, and vacuum cleaners has increased. Ownership of cars increased from 14 cars per 100 households in 1991 to 27 cars per 100 households in 1000. But while consumption of some goods has increased, consumption of some services that had been provided by the government has declined. This includes theaters and museums. And the deterioration in the overall health of the population was discussed in detail earlier. So the record on consumption is mixed. For most people, their income comes from their wages. The wage arrears problem still exists. A significant proportion of Russian workers did not receive their paychecks when they were due. Many waited for months. As of 1999, the Russian government owed an estimated 60 to 75 billion rubles to its workers. Private businesses owed another 70 billion rubles. Adjusting for inflation, the average monthly wage in July of 1999 was only 65% that of December of 1997. For awhile, many people had no money. Unpaid soldiers reportedly sold their weapons and uniforms. Many Russians resorted to barter (the trading of goods for goods) to survive. Russian companies also resorted to barter, paying their suppliers and even their taxes in kind. And many people moved into selfsufficiency --- growing their own food in small gardens near the cities, making their own clothes, and so forth. The situation is better for these people today than it was in the late 1990s. But wage arrears are still causing suffering. Our second goal involves efficiency (both allocative efficiency and productive efficiency). We have no measure of this. But the opening of the market economy would seem to have improved efficiency. First, as prices have been liberalized, they are more likely to be sending signals to companies telling them what goods and services are most desired by consumers. The response to these market signals could be impaired by the lack of competition within Russia. However, this may be offset by the increase in imports 13 from abroad. Second, as we noted in the section in Chapter 14 on the oligarchs, there is evidence that productive efficiency in the companies owned by the oligarchs has improved considerably. This should not be surprising as there was great waste under communism and since the owners of the companies are now trying to increase their profits. Our third goal involves equity. This was discussed in detail above. Inequality has increased in Russia and is now quite high. Poverty seems to have increased. A new class of very wealthy people has emerged. Clearly, the Russian economy is less equitable than it was before. Our fourth goal involves full employment and economic security. Clearly, Russia has more unemployment and less economic security than it did under communism. As of July of 1999, over 12% of all workers were unemployed. This has fallen since 1999 but is still relatively high. Not only have unemployment rates increased but the duration of spells of unemployment has also increased. And the government support for people unemployed or for people with low incomes has been reduced. For most people of working age (but not for retirees), economic life is less secure than it used to be. Our fifth goal involves price stability. As we saw, Russia experienced very rapid inflation during its transition. For 1992 – 1994, Russia even experienced hyperinflation. Consumers in Russia sometimes found that the price of a basic product, such as flour (or vodka), doubled in just a week. The rapid rise in prices virtually wiped out the value of the savings of the people (which, remember, were held in currency). Since the late 1990s, inflation rates have been lower in Russia. However, they have still been high by international standards. So while improving, Russia had not achieved price stability by 2005. However, it appears that inflation rates in Russia will be lower beginning in 2006. So achieving this goal is in sight. We have not discussed the other goals in these two chapters. One is environmental quality. As with most middle income countries, this is a major problem for Russia. Much of the water and the air is polluted. Another goal is military power. Because it is a nuclear power, Russia is more significant militarily than its economy would suggest. However, spending of defense in Russia has been reduced greatly since 1990. And Russia has been engaged in a long war in Chechnya without result. A final goal is freedom. Russia has established a democracy. But it appears that the situation has deteriorated since 2000 under President Putin. The government media dominate. The independent media have been harassed or censored. More than one prominent media critic of the government has been assassinated. There is some evidence that elections have been manipulated. As we have seen, bribery is still common. In the World Bank’s “graft index”, Russia ranks number 142 out of 160 countries. Corporate governance is very weak. Property rights are not assured. While it is certainly freer than it was under communism, Russia has a long way to go. The Russian people were told that the economic reforms would make their lives better. The jury is still out as to how well this will happen. Russia is a country with the 14 potential for great wealth. It has abundant natural resources, good agricultural land, a considerable amount of capital goods, and a reasonably educated population. But it cannot really become a fully developed country until some major changes in its economic system occur. Most importantly, there needs to be the creation of political stability and a system of well-defined property rights. Also there needs to be a large reduction in the amount of criminal activity. Enterprises need to be changed so that those who run them profit only if the enterprise performs well in markets. Banking and other financial institutions need to be better developed. A climate needs to be created that will encourage people, both Russian and foreign, to invest in new capital goods. President Putin has said that he will step down in 2008. Making these changes will be the main challenge for the next Russian President.